Signs you’re ready for project finance

Raising into a project rather than onto your corporate balance sheet takes your company's specific risk out of the equation, making it more palatable to investors. But if you seek out project financing too early – before either the tech or the project is actually isolated from your company – it won’t work out. To determine whether it’s the right time, there are some questions you should ask yourself first.

Josh Kaufman is CEO of Khasma Capital. We sat down with him to discuss the advantages and disadvantages of project fundraising, and seven factors that will influence your decision to seek out this type of financing over corporate.

When project finance makes sense

One major benefit of raising project financing is it typically comes with a cheaper cost of capital, unless you have a robust enough balance sheet that you can raise cheaper debt at the corporate level. 

The other advantage is that you’ll segregate your project from the corporate entity itself: so if something goes wrong, your corporate entity – unless it’s a guarantor – will be spared the worst of the impact. Plus, it can sometimes be easier to finance a project, and will diversify your capital mix with a different set of investors. 

From an investor’s perspective, as well as being easier to underwrite, the benefit to project finance is that it is lower risk. While this comes with lower returns, it’s a trade-off that the right investors are generally willing to accept. 

The downsides of project finance

Project finance can be legally complicated, meaning it’ll only be worth the headache and associated legal costs once your company reaches a certain size.

It can also create misalignment issues between investors, as the split can create  two different investor bases with different goals – this is why some project investors will do corporate investments in parallel. 

How to know you’re ready for project finance

1. Have you minimized commercial risk?
You need to have almost entirely eliminated commercial risk to be ready for project finance. That means if the plant's not built yet, you’ve found someone to build it with a fixed-priced EPC contract, and they’ve agreed to cover any cost overruns. You’ll have a fixed-price offtake agreement from a creditworthy counterparty, fixed-price feedstock agreements, and all the permits are done.

If securing all of the above isn’t possible, you’ll need to be as close as possible. Project investors will generally take one or two uncontracted risks, for example if everything is well contracted except for the feedstock some can diligence that component and get comfortable with the risk. The goal is to create as much certainty around your proforma as possible so that there are minimal areas that require forecasts. A general rule of thumb is project equity investors want to receive their money back within the contract durations.

A project investor only wants to invest in the project if they think they’ll receive predictable cash flows. If you have metal in the ground, but it doesn’t produce predictable cash flows, it’s technically a project, but it's not interesting to a project investor.

2. Have you minimized technology risk?
The adage states that venture is the world of dreams and infrastructure is the world of data. Demonstrate that the technology works using the same inputs, creating the same outputs, at the same scale, and over a meaningful period of time. In addition to the technology itself, is there any variance in the balance-of-plant that is contemplated in your design? Can you get an EPC firm or insurance provider to guarantee performance?

Familiarize yourself with the Technology Readiness Level scale. If you’re not at 8, you’re probably not ready for project finance.

3. Does the asset have value beyond revenue?
This applies mainly to lenders. If you want a project lender to believe there is downside protection on the basis that there is steel in the ground, you’ll need to communicate some value from the asset that is separate from the commercial revenue you expect to generate. For lenders to secure the investment against the assets of the project, you need to be able to show their worth. Don’t assume that just because there’s an asset, there’s downside protection – an asset only has value if it can generate cash or be resold. If it’s so unique that it's useless to anyone but you, it’s not worth anything. 

For instance, a lender didn’t want to underwrite the first hydrogen ferry because its commercial viability wasn’t clear – so they incorporated the cost of replacing the hydrogen propulsion with a diesel system. While there are not many hydrogen powered ferries, there are many diesel-powered ferries so that collateral value is easier to estimate. And even in a more mature sector like EV trucking, chargers and trucks aren’t getting financed by project finance investors because of a lack of data on their residual value. 

4. Is the project truly isolated from corporate risk?
Investors want to commit capital to an asset that is technologically de-risked and operator-agnostic. If you installed the technology and then disappeared, could another party step in and manage it successfully? If the answer is no, the investor is still taking corporate risk, which means the cost of capital should be the same as if it were a corporate financing, and largely eliminates the benefits of setting up a project financing. 

5. Does the return profile actually meet investor appetites?
While various factors like catalytic government funding have made project debt more accessible, project equity remains the hardest capital to raise. While large, stable investments can command high single digit equity returns, smaller projects in less mature sectors require approximately a 20% levered IRR for investors to bother with the headache. They might know your first project won't hit that target, so they will also want to see a pipeline for projects two, three, and four where they actually will make money.

6. Is the project big enough?
Project equity has a high bar. Unlike debt, which can be more flexible and secured for smaller equipment financing, project equity investors rarely consider deals below $20m, with many looking for at least $50m. If your project only needs $10m, it’s probably too small. 

7. Does your team have project development experience?
You need people in your team – or external fractional help – who have developed projects, raised project capital, and understand all the pieces that go into the puzzle. This is not a plane you build while you’re flying it. 

Josh Kaufman is the Co-Founder and CEO of Khasma Capital, an investment and development firm backing innovative energy transition technology companies  in the US and Canada.

With a background in business development, M&A, and infrastructure for multinational energy companies, Josh is an expert in identifying, investing in, and scaling critical infrastructure projects across North America. In his role at Khasma Capital, Josh oversees the fund investment and long-term execution strategy to support a portfolio of companies active in the Circular Economy and Emerging Energy Transition sectors.